Bruce Berkowitz's Conviction in Canadian Natural Resources May Have Been Hype

I've been long term bullish on oil for several years. I think it is just a matter of simple math. The super giant oil fields discovered decades ago produce less oil every year and we just can't bring enough of the smaller fields that are discovered in recent years on quick enough to offset declines AND grow daily oil production. Globally, we have pretty much reached the fastest rate we can produce oil on a daily basis. But this isn't just a supply issue as demand for oil marches ever higher year after year as the developing world adopts a more Western lifestyle.

A peak in supply and an ever growing demand. Prices have only one way to go.

One thing I have long noticed is that most of the better known professional investors have not positioned their portfolios to take advantage of higher long term oil prices. One very well respected investor who for a long time did seem to do so, however, was Bruce Berkowitz of Fairholme. Berkowitz's favorite oil and gas investment for several years was Canadian Natural Resources (NYSE:CNQ). In 2006/2007 Berkowitz didn't just like Canadian Natural, he loved it. And he risked a lot of his shareholder money on it. Consider the top 10 positions in the Fairholme Fund on May 31, 2007:

How many mutual funds available to retail investors have you seen that have over 34% invested in its two largest positions ? Clearly at the time Berkowitz loved both Berkshire and Canadian Natural. But that doesn't tell the entire story because Berkshire is basically a very diversified investment itself with many different businesses and many different marketable securities. Canadian Natural, on the other hand, is a single heavily concentrated bet on one oil and gas producer and one management team.

Berkowitz talked frequently about Canadian Natural and its management team. And he also indicated a belief in high oil prices. I recall very clearly this interview with Berkowitz which piqued my interest in CNQ. The Fairholme team explained their belief in oil prices as follows:

"Our only macro view about energy was that the supply of cheap oil was disappearing. There's plenty of oil, but you just can't find it and produce it cheaply. That makes the likelihood we return to $20-per-barrel oil very low.

The physics make sense to us that this is a resource that's being used up. Every major field outside of Saudi Arabia is in decline. Those people who talk about this endless supply of oil regenerating and bubbling up from the center of the earth, where is it?

Then we started working through the alternatives: nuclear power, solar, wind, oil shale, coal-to-gas. I made myself crazy one weekend trying to figure out the potential for ethanol. All of these have their own problems – from safety, to capacity constraints, to cost, to lead times – and it's going to be hard for any of these to compete with oil even at today's prices.

There are so many scenarios that would take us off that knife-edge of supply and demand. Can you imagine if Al Qaeda succeeds in taking out a Saudi pumping facility or sinks an oil tanker in port?"

Sounds sensible to me. And they had the following specific comments about Canadian Natural:

"Right now Canadian Natural produces more than 500,000 barrel equivalents per day in traditional production, which will roughly double over the next seven years as Horizon starts up and they develop other conventional assets.It is an enormous project. The first stage will cost $6 billion to begin producing synthetic crude in three years. They'll spend more than $15 billion on the entire project by the time they're done. But the amazing thing is that it will all be funded from free cash flow, with no additional debt.

They're looking at an operating cost of less than $18 per barrel coming out of Horizon. They've based the economics of the project on $28 oil, and at that level expect to earn a double-digit IRR.

At $60 it still trades at less than 10x free cash flow of about $6.50 per share, for a company with the ability to double production and triple free cash flow over the next eight years without having to add any new assets. This is one where we don't really have an upward value range on it, because the numbers get crazy. They have six billion barrels of recoverable reserves in the oil sands and another three billion barrels in heavy oil/bitumen properties. That's nine billion barrels of oil before you even talk about their conventional oil and gas reserves, which are approaching the equivalent of 2.5 billion barrels.

The assets aren't exactly the same,but Chevron bought Unocal in 2005, onaverage, for $12 per barrel in the ground, although much of that related to lower-value gas reserves. Apache Corp. announced just last week that it paid the equivalent of $22 per barrel in the ground to buy 18 Gulf of Mexico properties from BP. Applying anything like those numbers to Canadian Natural's assets, and, as Bruce said, the upside does get crazy."

At the time this interview took place the stock price of CNQ was about $60. Berkowitz and team sold their huge position in 2008 when oil spiked to $150 and CNQ's stock price hit $100. Smart move as oil subsequently crashed and CNQ dropped as low as $40.

What I don't understand is that given their long term bullish view on oil and belief that CNQ is likely worth multiples of $60 per share, why didn't Berkowitz and team reload on CNQ when it dropped back as far as $40 ? And for that matter, why don't they own it today at $78 if they believed in their prior comments about oil prices and the CNQ valuation. Since the interview CNQ has performed well as a company with production now around 600,000 barrels of oil equivalent per day.

In their 2006 annual report to shareholders Berkowitz wrote this about CNQ's leadership:

"A great management team can still knock the cover off the ball in a commodity industry (think: a well known owner/manager of a commodity insurance business based in Omaha). Given time, we expect Murray Edwards to challenge Warren Buffett's superb track record."

The Fairholme thesis on oil has so far proven to be exactly correct. Their thesis on CNQ growing production has been accurate. And the stock price is still very cheap compared to their valuation work. So why doesn't Fairholme still own it? Was it all just hype to promote a position ? It seems strange to compare a manager to Warren Buffett and then trade the stock only for a fairly short term profit.

I'd love to know as I think CNQ looks pretty attractive.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.